There is an opinion piece in today’s Wall Street Journal worth commenting on. Todd Zywicki writes that the Consumer Financial Protection Bureau (CFPB) under its previous leadership “pummeled American consumers and the economy while doing little to promote financial stability.”

He argues:

The pain was especially acute for low- and middle-income consumers who lost access to credit cards, faced higher bank fees and reduced access to free checking, and found it harder and costlier to obtain mortgages, especially as first-time homebuyers. In response, consumers turned to payday loans and alternative products as financial life rafts—only to have Mr. Cordray poke holes in them by imposing regulations that would effectively outlaw payday lending.

He is on sound footing in regards to the regulatory burdens imposed on small banks and credit unions. His comments regarding consumer choice may look good on paper but to my eye appear ignorant of the reality on the ground.

This passage in particular irks me:

When the CFPB prototype was first proposed nine years ago, I wrote in these pages that the architects of the new agency should “treat borrowers like adults.” Instead, Mr. Cordray’s CFPB viewed consumers as too dumb, irrational or vulnerable to make their own decisions about whether to enter into a contract with an arbitration clause, take out a payday loan, or bargain with a car dealer over an auto loan.

The problem is that the people who are targeted for “alternative” credit solutions tend to be desperate individuals of limited financial sophistication. They are precisely the kind of people who lack the financial literacy to make informed decisions regarding things like arbitration clauses. Or compound interest, for that matter.

When I worked in consumer lending, I frequently encountered these borrowers. In fact, we had a couple of subprime lenders up the street from our office (we sat at the nexus of several communities varying dramatically in wealth). Disgruntled customers would often drift over to us when the punishing cost of their loans finally dawned on them. Even at the height of ZIRP here in the US, they were carrying mortgages at 10-15% and auto loans at 20%+.

None of these people understood the loan docs they had signed. Some of them might have been victims of deliberate mis-selling. However, I believe the overwhelming majority were simply financially illiterate. I could tell I had finally gotten through to one befuddled borrower on compound interest when his face lit up and he exclaimed, “so that’s how Warren Buffett does it!”

The key issue here is that the only way to make money as a lender is to charge punitive interest rates. Subprime borrowers are genuinely awful credits.Default rates are high and recoveries are low. (what quality collateral do you suppose someone is bringing to the table when he is willing to take a mortgage at 10% with Prime at 3.25%?)

There is certainly an argument to be had about whether the government should be in the business of protecting financially illiterate consumers from themselves. Mr. Zywicki obviously does not believe so. But I feel it’s important to at least properly frame that debate.

UPDATE: After some discussion on this subject with others, I developed the below analogy to cigarettes.

People get addicted to cigarettes, which are bad for their health and have broader negative impacts on society at large (read: healthcare costs). So, the government imposes punitive taxes on cigarette consumption. You remain free to buy cigarettes, but you are penalized for doing so. The reason is that the rest of us are forced to bear the cost of your bad habit.

Subprime lending is similarly corrosive. Subprime loans are “unhealthy” for the borrowers. They also undermine social cohesion more broadly by promoting distrust of the regulated financial system and markets in general. So, why should we as a society promote the proliferation of this type of financing?

As part of the above referenced discussion, I pulled a OneMain Financial (OMF) 10K. In fiscal 2017, OMF took a $955 million provision against something like $2.4 billion of net interest income. They are reserving something on the order of 40% of net interest income for expected loan losses.

On the one hand, I can look at this as the high cost of “serving” this customer demographic. As noted above, I have no illusions about these consumers being awful credits. Subprime lending is not a rainbows and butterflies kind of business. Far from it. From the business point of view, eggs must be broken to make the omelette.

On the other hand, I question the ultimate economic purpose of the enterprise. To me it looks a lot like a means of extracting wealth from the poorest, least financially literate communities and transferring it to management and shareholders (I have similar objections to our use of lotteries and casinos as regressive taxes on the poor). Such businesses certainly have a right to exist. However, they are businesses that should be kept on a tight regulatory leash.

I have often written about the need to be discriminating in the information you consume. Particularly as an investor. The overwhelming majority of information you will encounter on a daily basis is random noise: breaking news; talking heads shouting at each other over the latest cultural or political outrage; mindless entertainment.

Of all the noise you encounter, mindless entertainment is probably the least damaging. I would take an episode of Hell’s Kitchen over an hour of CNN, Fox News or CNBC any day.

There is an excellent podcast available through the FT Alphachat Series featuring Matt Klein’s interview of Marcus Noland, a researcher at the Peterson Institute for International Economics who has spent a significant amount of time studying the North Korean economy.

The background information included with the podcast is also worth reading. This section in particular struck a chord with me:

The North Koreans depended on subsidies from the Soviets to survive, particularly the ability to buy oil and refined petroleum products at “friendship” prices. As the Soviet economy creaked under the combined weight of the war in Afghanistan, low oil prices, and the perceived need to match America’s defence buildup, these concessions started to disappear. By the late 1980s the North Koreans were paying more to the Soviets than they were getting.

One of the downsides of the North Korean obsession with self-sufficiency was that the country ended up with the most industrialised agricultural sector in the entire world. The only way the North could hope to feed itself without imports was to bathe the soil in fertiliser and other chemicals. (Of course, that required imports of energy from the Soviets, but apparently that was okay…) The North Koreans also expanded farmland by cutting down trees, which eventually led to soil erosion, silted rivers, mudslides, and floods.

All of this meant that the collapse of the Soviet Union made the North Koreans extremely vulnerable to food shortages. In the mid-1990s these shortages combined with the failures of the North Korean state to efficiently distribute the food they had and secure enough food from abroad through aid and imports. The result was a famine that killed about 3-5 per cent of the North Korean population — around 1mn people. (Regular listeners will think of Cuba’s “special period”, which killed far fewer people but had similar causes.)

Without spoiling the podcast here are a couple of high level takeaways from my POV:

Centrally planned economies do not work. In the cases of the Soviet Union, China, North Korea and Cuba, central planning, at its best, manged to produce substandard consumer goods. At its worst, central planning actively contributed to the deaths of millions through the misallocation of resources. The misallocation of agricultural resources has proven particularly devastating.

These lines from the 1965 film version Boris Pasternak’s Dr. Zhivago are fairly evocative:

Don’t be too impatient, Comrade Engineer. We’ve come very far, very fast […] Do you know what it cost? There were children in those days who lived off human flesh. Did you know that?

Autarky does not work. North Korea is probably the closest thing we have to a true autarky. And yet, even in its much diminished state the North Korean economy is still not a true autarky! Initially it was dependent on the Soviet Union. Now it is dependent on China.

Markets do work. The Soviet Union, China and North Korea each developed market-based solutions to the massive inefficiencies created by centralized economic planning. In the early days of the Soviet Union, Lenin launched the New Economic Policy (later abolished by Stalin). In China, it is the advent of a “socialist market economy” (which, unfortunately, has evolved into a massive kleptocracy). In North Korea, market-based solutions to famine arrived in the form of small scale, informal trading relationships, as well as a black market for food.

There is much more than this in the podcast, however. So do give it a listen.

I am a fan of parsimony, in both financial modeling and life. In the spirit of parsimony, I think I can distill my core values down to three quotes from Marcus Aurelius’s Meditations:

Quote #1

Be like a rocky promontory against which the restless surf continually pounds; it stands fast while the churning sea is lulled to sleep at its feet. I hear you say, “How unlucky that this should happen to me!” Not at all! Say instead, “How lucky that I am not broken by what has happened and am not afraid of what is about to happen. The same blow might have struck anyone, but not many would have absorbed it without capitulation or complaint.”

Quote #2

When you wake up in the morning, tell yourself: The people I deal with today will be meddling, ungrateful, arrogant, dishonest, jealous, and surly. They are like this because they can’t tell good from evil. But I have seen the beauty of good, and the ugliness of evil, and have recognized that the wrongdoer has a nature related to my own—not of the same blood or birth, but the same mind, and possessing a share of the divine.

Quote #3

Words that everyone once used are now obsolete, and so are the men whose names were once on everyone’s lips: Camillus, Caeso, Volesus, Dentatus, and to a lesser degree Scipio and Cato, and yes, even Augustus, Hadrian, and Antoninus are less spoken of now than they were in their own days. For all things fade away, become the stuff of legend, and are soon buried in oblivion. Mind you, this is true only for those who blazed once like bright stars in the firmament, but for the rest, as soon as a few clods of earth cover their corpses, they are ‘out of sight, out of mind.’ In the end, what would you gain from everlasting remembrance? Absolutely nothing. So what is left worth living for? This alone: justice in thought, goodness in action, speech that cannot deceive, and a disposition glad of whatever comes, welcoming it as necessary, as familiar, as flowing from the same source and fountain as yourself.

Here is how I read and apply these as core principles for living:

Quote #1: Strive to stand strong in the face of the chaos and tumult life inevitably brings. This striving creates meaning, and allows you to shape your sense of self.

Quote #2: All human beings are worthy of dignity and respect. At the extreme, even those who seem “bad” or “evil” share many of our traits. On a less extreme level, those we disagree with generally have good reasons for believing the things they do. Strive to empathize and understand a person’s reasoning before rushing to judgement. In doing so you will develop a richer understanding of the world and the people around you.

Quote #3: Wealth, power and status are at best impermanent. It is nice to have them, but they do not create meaning in and of themselves. Wealth, power and status are all subject to the wheel of fortune. They are impermanent. Ask yourself: in a post-apocalyptic hellscape, where wealth and status are irrelevant, how would I create meaning? (see also: The Road by Corman McCarthy)

(See Part I for the background on this post. As usual, none of this should be treated as financial advice as it does not take your personal circumstances into account. If you want advice, talk to a professional advisor. Trust me, there are plenty of highly competent, ethical professionals out there who are excited to help you achieve your goals.)

After sharing the original post with some savvy friends, subsequent discussion stirred up some additional ideas for questions and answers. So here are some additions to our little Socratic dialogue.

So back to this active versus passive investing thing. It sounds like you are pro passive?

If I absolutely have to take a position, I would say most people are probably better off investing passively. Unless they happen to be really good at investing actively, of course.

Ugh. There you go again. But how can I figure out if I’m good at investing actively?

We can look at your returns 20 or better yet 30 years from now. That will give us a pretty good idea.

Double ugh. How can I know BEFORE I start making active bets? If I start down this path and it turns out I suck I may lose a lot of money.

You can’t know ahead of time. Don’t waste your time trying to “know” things that are fundamentally unknowable.

There are certain skills and psychological traits that may make you a better active investor than someone else. For example, skilled poker players typically make for good active investors. They intuitively understand expected value, probabilistic thinking and mental models for decision making under uncertainty. They understand the interplay between luck and skill in determining outcomes. Psychologically, they know how to handle a “bad beat” (or several) without blowing up. They are used to making calculated bets, and therefore also have an intuitive understanding of risk management.

If you are a good portfolio manager (you’ve got “poker skills”), you don’t have to be a great financial analyst to do well. The reason for that is that randomness plays a huge role in the markets (as it does in life). Thus it is more important in the markets to optimize decisions under uncertainty than it is to be “right” analytically. You still need to have an above average understanding of accounting, capital markets and basic principles of economic value creation to avoid making stupid, otherwise obvious mistakes. These things are easier to learn than “poker skills,” if you are willing to put in the time and effort.

Ultimately, if making decisions under uncertainty makes you queasy, I suspect you will have a difficult time investing actively.

That seems complicated and unhelpful.

Then invest passively. Or find someone you trust and respect to develop an active investing program suited to your goals (whether that is picking managers or individual stocks).

Okay. Let me try this another way. What I have really been asking this whole time is this: what is The Best Thing To Do?

There is no Best Thing To Do. There is only The Best Thing For You To Do.

So what does YOUR portfolio look like, big shot?

Approximately 70% of my investable net worth (ex-cash) is invested in actively managed strategies that should earn something like broad market returns over time. If I am lucky maybe a little extra. If I am unlucky maybe a little less. The remaining 30% is invested in a concentrated portfolio of individual securities with the goal of generating extraordinary capital appreciation over a multi-decade time horizon.

How do you know these managers will perform well over time?

I don’t. Honestly, just try to put money with folks doing sensible things who I think will be good stewards of my capital over a multi-decade time horizon, and who I believe charge reasonable fees for managing my money. That frees me up to do the work I want to do on individual securities, which will potentially compound value at a much higher rate over time.

Why this 70/30 split? Why not just go all in on the stuff that you think will go up the most?

Because if 30 years from now it turns out I really sucked at this I will not have laid waste to my net worth or my family’s financial security.

I was inspired to write this post by a conversation I had this afternoon at a lunch event. I sat next to a gentleman who has been working in the capital markets for about 40 years. We were discussing active, passive and smart beta strategies. Our conversation revolved around the idea that much of what passes for investment strategy is an incoherent jumble of half-truths and gross oversimplifications. The reason for this is that investors are always looking for THE ANSWER. You can move a lot of product pretending to have it.

What is THE ANSWER?

It is the magic asset, or strategy, or star manager that beats the market like clockwork. It is the alluring promise of “equity returns with less risk” (whatever that’s supposed to mean). It is the siren song that drew investors to hedge funds in the mid-2000s and draws them to private equity and venture capital today.

In reality of course there is no magical asset class, strategy, or manager. There is only the ever-shifting landscape of the capital markets. In capital markets, the only constant is change. Fortune ebbs and flows. Just when you think you have the game figured, the game will change. Count on it. George Soros calls this “reflexivity.” The game changes in response to how we play it. Don’t like it? Too bad. That’s America.

People do not like change. They especially do not like change of the reflexive kind. And don’t get me started on cognitive dissonance. Nothing wrecks Average Joe’s head quite like trying to hold two contradictory ideas in his head at the same time. Because people prefer order, stability, predictability and logical coherence, we as financial professionals tend to coddle them. We show them charts of historical capital market data and pretend it is meaningful. We make neat little graphs showing historical drawdowns and recoveries and emphasize that things always turn out okay in the long run. What we don’t give them is THE TRUTH. Most of them can’t handle the truth.

Because THE TRUTH is that there is no single ANSWER. There is only a long list of general principles in constant conflict with one another. And the reality is that sometimes things don’t turn out okay in the long run.

In that spirit, I will endeavor to answer some common questions as truthfully as I can. Note that as always, this is not financial advice. I have no idea what your personal situation may be. I am not in a position to be advising you to do anything. And anyway when you are through reading you will probably be more confused than when you started. Silver lining: you will be incrementally closer to understanding the truth about investing.

So here we go.

Is it better to invest actively or passively?

It depends on what you want to achieve.

If you are comfortable earning broad market returns, and you want to maximize tax efficiency and minimize costs, passive strategies are probably the tools you are looking for.

If your goal is to generate extraordinary capital appreciation, you must concentrate capital in equities with extraordinary compounding potential, and you must hold these positions for a very long time. Perhaps that means starting your own business. Perhaps it means owning a concentrated portfolio of individual stocks. Perhaps it means investing a significant portion of your investable net worth with a single asset manager. Warren Buffett didn’t get to be a billionaire buying index funds, no matter what he writes in his shareholder letters.

What if the broad market doesn’t return what it has historically and it ruins my financial plan?

Too bad. There is no law saying you are entitled to a particular return over time. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

What if I can’t pick the right stocks/managers/business opportunity and I lose all my money?

Too bad. There is no law saying you are entitled to a particular return over time. However, if you are unwilling to devote a significant amount of time learning about business, accounting, capital markets and psychology, it is unlikely you will do well investing. Don’t be ashamed of that. It just means you will need to seek out professional advice, the way I sought out a coach when I wanted to change careers from writing to finance. You will be better for it in the long run, and contrary to what you read in the news there are many highly competent advisors out there who want to help you achieve your goals.

What if I can’t pick the right stocks/managers/business opportunity and I significantly underperform the broad market averages?

Too bad. There is no law saying you are entitled to a particular return over time. If you are that concerned about underperforming the broad market averages you should invest passively. The future is fundamentally unknowable. The best way to protect yourself from unexpected financial shocks is to save a significant portion of your income, carry as little debt as possible and invest a portion of your savings in personal development. Note that all of those things are things you can control, unlike the financial markets and the macroeconomy.

How do I know I am picking the best investment manager?

You don’t and you can’t. Don’t waste your time and energy thinking about this. If you go this route, focus more on avoiding the worst managers, and developing an investment discipline you can stick to over time, through thick and thin.

Isn’t it true that no one can beat the market?

The average investment manager will not beat the market over time, especially net of fees and taxes. However, that is the “average” and there are many talented managers who do outperform over the long run on a net basis. Unfortunately, most of the managers who outperform over the long run will suffer extended periods of underperformance, and most investors will not be sufficiently disciplined to stick around for the good times. In my opinion, picking managers is every bit as difficult as picking stocks. Perhaps even more so.

So if I am invested with a poorly performing manager I should just hold on longer until the good times come?

No. Poor performers often continue to perform poorly, and this poor performance is exacerbated by outflows of investor capital. If this persists for an extended period, it will render the asset manager’s business non-viable and the fund will liquidate, crystallizing your losses.

So how do I know if performance will turn around?

You don’t know. And you can’t.

Grrr… this is getting annoying. Fine. How can I try and figure it out?

Better, grasshopper. You are slowly learning to ask the right questions!

You need to understand the manager’s investment philosophy. You need to understand the way she looks at the world, the way she thinks about value creation and what she perceives as her “edge.” Is she focused on long run intrinsic value creation or the shorter term re-rating of market expectations? (Hint: when she models companies, does she use a discounted cash flow or earnings methodology, or does she compare price multiples such as EV/EBITDA to peer companies?)

You need to assess whether her portfolio is in sync with how the capital markets are trending, or whether she is a contrarian. If she is a contrarian, you need to assess whether and when the market will turn in her favor, and whether you can hold out for that long psychologically.

You also need to understand her investor base, the health of her business, the loyalty of her team and her personal goals. If she is losing assets and is motivated primarily by business success (versus “winning” at the game of investing) she will be more likely to liquidate (a.k.a return investor capital to spend more time and energy with family).

This sounds hard.

Why should it be any easier than mastering any other technical or artistic skill?

Well, I can trade commission free on Robinhood.

You can cook elaborate meals in your home kitchen, too. Yet you don’t expect your butternut squash risotto to earn three Michelin stars.

Thinking back on the first part of this conversation, I notice you repeat yourself a lot.

Markets are ecosystems. And like any ecology, markets can come to favor organisms with certain traits over arbitrary time periods. In the natural world, dinosaurs flourished when the global climate favored their biology. Then, quite suddenly, that changed. National Geographic tells it like this:

Scientists tend to huddle around one of two hypotheses that may explain the Cretaceous extinction: an extraterrestrial impact, such as an asteroidor comet, or a massive bout of volcanism. Either scenario would have choked the skies with debris that starved the Earth of the sun’s energy, throwing a wrench in photosynthesis and sending destruction up and down the food chain. Once the dust settled, greenhouse gases locked in the atmosphere would have caused the temperature to soar, a swift climate swing to topple much of the life that survived the prolonged darkness.

This is not so much different from those who got wiped out holding large positions in XIV. Short volatility strategies thrived in a market environment that for years has favored long duration assets (long term bonds, high growth stocks, cryptocurrencies) and dip-buying any market decline. When the market environment changed, suddenly and violently, the short volatility trade blew up. Years of gains vaporized in a single day.

Over the past couple of years I have begun to believe there are tremendous benefits to viewing markets through an evolutionary and/or ecological lens. I think this helps you focus on a range of variables impacting the markets, versus wearing blinders that limit you to valuation, momentum, or whatever it is you consider your “thing.” So when a particular asset class catches a strong bid, here are some things I consider:

If this is a cash flow producing asset, what is the relationship between the intrinsic value of the cash flows and the market price? For stocks it is not especially difficult to use the market price and a simple DCF model to derive a market implied IRR. For bonds just check the yield to maturity, yield to call, yield to worst, etc. This gives you an idea of how investors are pricing risk.

Who is driving flows into or out of a sector or asset class? Mutual funds look at the world differently from hedge funds, which look at the world differently from banks and insurance companies. Each of these players has different objectives and constraints, which will impact their behavior as market conditions change.

Are the players driving flows into the asset weak or strong hands? Retail investors are the weakest hands in the markets. I consider many mutual funds weak hands also (depends on the fund family). Mutual fund flows are driven by retail investors and their financial advisors, who are notorious for chasing performance.

How highly levered are the players driving flows into the asset? Leverage can drive extraordinary returns, but it also creates fragility. When deleveraging events occur, prices can collapse suddenly. Many of the short volatility players who got blown up recently didn’t understand the magnitude of the leverage embedded in their positions.

What exogenous factors are driving flows into this asset class? Is an asset in demand due to expectations for low interest rates, low inflation, or other macroeconomic variables? Macro conditions are fickle, and human beings are notoriously poor forecasters.

The most fragile market ecology is one where weak hands are using leverage to play some exogenous variable with known unstable or mean-reverting properties. From this perspective, systematically shorting volatility was stupendously risky–a form of Russian roulette. A large number of retail investors were trading instruments (volatility linked ETPs) with significant embedded leverage, placing a massive directional bet on low rates, low inflation and market momentum.

A market ecology I believe is extremely fragile, but hasn’t blown up yet, is high yield debt. This is an asset class that is highly leveraged by definition, and has attracted massive flows from yield-starved investors. Strong flows have pushed prices up to the point where future expected returns are dismally low, and protective covenants are the weakest on record. Perhaps worst of all, there is a liquidity mismatch between the ETPs (HYG, JNK, etc.) providing investors with easy access to high yield debt and the underlying high yield bonds. For a preview of what happens when a liquidity mismatch meets a stampede for the exits, refer to Third Avenue Focused Credit.